Scott Sumner  

Real and monetary shocks, a numerical example

The Question I Didn't Ask Nate... Prove-Me-Wrong Prizes...

Here's Tyler Cowen:

Closer to the central point I think is Scott's claim: "Any "real shock" that reduces NGDP expectations because the Fed responded passively is also a monetary shock." For me that is a real shock with insufficient monetary accommodation, not a "real shock," as Scott gave it quotation marks, and also not a monetary shock. I prefer not to smush real and monetary shocks together in that fashion, and I think some ngdp theorists are trying to claim an explanatory victory by fiat by doing so. I do not think this matters for policy, and as I've stated I am very sympathetic to market monetarist recommendations. But in terms of explaining downturns, again, I think they are trying to claim some victories by fiat.

Here I think it would help clarify things to do some examples with numbers. Let's assume a negative real shock---say the government orders companies to give everyone a 5% raise immediately. For simplicity, let's assume that this policy shock reduced aggregate hours worked by 5%, for any given NGDP. (The specific numbers don't matter; you simply need to assume some sort of negative real shock. If you don't like mine, then assume something else, like mandated vacations.)

Of course real shocks often become entangled with monetary policy, and thus NGDP may also change. Here are three options:

a. The monetary base is not changed, and the wage shock causes V to fall by 3%, as there is less demand for credit to finance new investments. Now wages are up 5% and NGDP is down 3%, reducing hours worked by 8% (perhaps). I'd say the real shock reduced hours worked by 5%, and the monetary shock by another 3%. As we will see, it's not clear what Tyler would claim.

b. The Fed increases the base enough to offset the shock to velocity, keeping NGDP unchanged. Now hours worked fall by 5%. I claim that's now a 100% real shock.

c. The Fed increases the base enough to raise NGDP by 5%, and hours worked don't change. Here we have a negative real shock and a positive monetary shock.

Now what would Tyler Cowen make of all this? You might be tempted to claim that he would regard the entire 8% decline in hours worked in case A as a real shock, as monetary policy was "passive" in that case. But I fooled you with framing techniques. There is no reason to assume that Tyler would consider a fixed monetary base as a "passive" monetary policy. Indeed in some of his recent posts he seems to suggest that a stable interest rate target is a passive monetary policy. Thus he characterizes the 1/4% rate increase in December as a small tightening.

The problem here is that policies that look passive in one dimension look active in another. A stable base will often be associated with changing interest rates, and vice versa. There is no generally agreed upon metric for determining whether a central bank is "doing something", and how much it is doing. The Fed cut rates from 5.25% to 2% in late 2007 and early 2008, with doing anything to the base. Was that passive? I agree with people like Ben Bernanke and Michael Woodford, that the most useful policy indicators are outcomes indicators, such as inflation and NGDP growth (obviously I prefer NGDP growth.)

Suppose you have a knife wound that leads to an infection. I consider those to be two distinct problems. The knife wound needs sewing up. The infection needs antibiotics. We need a monetary policy that prevents real shocks from infecting NGDP, because when they do so it causes additional problems for the economy, above and beyond the losses directly attributable to the real shock. In the example above, the foolish wage policy cost us 5% worth of hours worked. But let's not compound the damage with a monetary policy that fails to stabilize NGDP, and hence causes even greater losses.

In fairness, Tyler agrees with the logic of NGDP targeting, but not the logic of blaming the central bank for failing to do the optimal policy. So maybe it's just a question of semantics. But semantics matter, and the more pressure we put on central banks to excel at their jobs, the more we demand from them in terms of stable NGDP growth, the better they will do.

Let's start characterizing unstable NGDP expectations as "reckless monetary policy shocks." It doesn't matter if it's true or not, it's useful.

Update: Several commenters pointed out the medical metaphor was misleading. I didn't mean to suggest the doctor caused the infection by failing to treat the illness. The point of the metaphor was that a given shock can product a completely unrelated problem. The Fed is more like a doctor who is hired to watch over you every single second of the day and make sure you have the optimal amount of antibiotics in your bloodstream at all times. (If we want to stretch the metaphor to absurd lengths.)

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COMMENTS (14 to date)
Chris writes:


I think you're right that this is just a semantics issue, but I'm still a bit confused. Would you consider b a passive policy even if the central bank targets 5% NGDP growth? If the central bank simply hits their target, how is that a positive shock when everybody expected that to happen anyway? And why is NGDP the right measure at all for a central bank that doesn't target NGDP? If a central bank targets inflation and hits their target, why wouldn't somebody be justified in saying monetary policy was passive (even if NGDP fell)? What if they target interest rates or the monetary base?

In your knife wound example, if a doctor failed to administer the right dose of antibiotics I think most people would say they were too passive and that they could have prevented the infection with a more active policy. But I don't think anybody would say the doctor caused the infection, they just failed to prevent it. In 2008, the Fed not only hit the lower bound, but also expanded the monetary base to unprecedented levels. In other words, they flooded the body with antibiotics, but the infection still spread. You can always argue that the policy was not enough or that some other medicine (NGDP futures market) would have been better, but I think you lose people when you argue that monetary policy was "tight" despite the Fed doing more to try to loosen than they had ever done before.

I guess the problem is that there is no objective level of tightness since it depends entirely on context. Every time somebody says policy was tight we should replace it by "too tight given the current state of the economy." Forget about what counts as tight or loose or active or passive and simply ask whether things would be better if the Fed had done more or less.

Brian Donohue writes:

Good stuff. Love to get Tyler's reaction to this.

Don Geddis writes:

@Chris: Good questions (and I like your conclusion), but I think you have bought into the wrong framing.

Sumner basically suggests that "passive" is not a useful adjective for monetary policy. We should eliminate all discussion about whether a central bank is "active" or "passive". There is no coherent definition, and there are no useful consequences for attempting to make such a distinction. A central bank is a thermostat, charged with keeping the temperature on target. It is always active, under all conditions, never passive.

(And thus the "doctor caused infection" is an analogy that is stretched too far. A thermostat is always to blame if the house interior is at the wrong temperature. Assuming it has a sufficiently powerful AC and furnace, of course -- which central banks do in fact have.)

"there is no objective level of tightness" Sumner has proposed NGDP expectations deviating from trend, as the objective assessment. "...since it depends entirely on context." Yes! Exactly! It depends on context. But that doesn't make it "not objective".

"Forget about what counts as tight or loose" No, just make it context-sensitive. "Forget about what counts as [...] active or passive" Yes! Exactly!

Scott Sumner writes:

Don and Chris, good point about the infection metaphor, I'll change it.

Chris, You said:

"but I think you lose people when you argue that monetary policy was "tight" despite the Fed doing more to try to loosen than they had ever done before."

This is what I don't accept. Most people mean rates cuts when they point to a central bank being active. I'm not saying that's your view, but it's the most common view of action. But that implies monetary policy is incredibly contractionary during hyperinflation, when rates are very high, which is just crazy.

Now from there we can go to other metrics, like changes in the base. But they all have problems. So why not pick the most useful one?

And yes, if the target were 5% NGDP growth then I'd consider that passive. In this example I was looking at a point in time, not a 12 month period.

Thanks Brian.

ThaomasH writes:

I think the semantic issue around "tight" and loose takes pressure OFF central banks compared to just saying what ought to be done. Don't try to sell "passive tightening" as a description; say the Fed needed to crank up the QE machine (or devalue the dollar, or impose negative IORs, or whatever policy you favor).

Chris writes:


I agree with you that measuring tightness through interest rates is misleading, but NGDP is also misleading. Shouldn't we focus on what the central bank directly controls? The Fed sets the discount rate and reserve requirements, and conducts open market purchases. If they change none of those things, in my mind there is no way to consider that anything other than passive (not tightening or loosening). Market conditions then decide if that passive policy is too tight or too loose.

If stabilizing NGDP requires increasing the monetary base by 2 trillion is there no difference between a central bank increasing it by 1 trillion and not increasing it at all? For me, passive implies literally doing nothing, so the second is a passive policy while the first is active (even though both are too tight). The dictionary definition of passive is "accepting or allowing what happens or what others do, without active response or resistance." Maybe the resistance wasn't enough, but I don't think you can say that the Fed didn't resist.

I have a problem with the entire premise of "passive tightening." Tightening is an action. The Fed actively loosened, but the market tightened faster so policy ended up being too tight. I agree with ThaomasH. Forget about tight and loose. Just say it should have been tighter or looser than it was.

Scott Sumner writes:

Chris, Here's my problem with your claim. I think in the back of your mind you have a notion that other people agree with you, and that I am the outlier. But I see almost no one define passivity the way you describe.

For instance, how would you describe Volcker's policy of slowing the growth rate of the money supply? Based on what you just told me, it would have to be viewed as an expansionary monetary policy, as the money supply increased. But most people regard it as contractionary, because the growth rate of the money supply slowed.

Obviously you are free to describe the stance of monetary policy any way you wish, but don't assume others will agree with you. At least in my case lots of big name economists agree with my "outcomes" approach, including Bernanke and Woodford.

Also keep in mind that changes in the tools you describe are far less important than signals of future changes in those tools. So does that signaling count as policy?

Philo writes:

"There is no reason to assume that Tyler would consider a fixed monetary base as a 'passive' monetary policy." Nor is there any reason to assume that *you* would do so, and I thought you would *not* do so. Yet you did so, in your initial presentation (of the three alternative scenarios). Confusing!

In a comment on Tyler's blog I attributed to you the view that "the stance of monetary policy is to be judged relative to the expected path of NGDP one or two years into the future; if the Fed allows or causes this to *fall*, it has *tightened monetary policy*." Did I misstate your view?

Chris writes:


OK you're right. I was thinking too simply. If the Fed changes expectations about the future path of policy we should also consider that an active policy. Then would I be right to say that meeting expectations is a passive policy? But if that's true, then why would we be able to use NGDP as a measure of tightness when the Fed doesn't target NGDP? We're back to one of my original questions. Suppose the Fed targets 2% inflation, everybody expects the Fed to hit its target, and it actually hits its target. If we go into recession anyway (say NGDP growth is 0), was monetary policy still tight?

I do agree with you on almost everything, but I also agree with Tyler and Bob Murphy that sometimes market monetarists seem to be cheating a little bit with their language.

ChrisA writes:

It is a pretty pointless semantic debate around whether or not the Fed can or is passive or active. Even the Austrians believe that the actions of the Fed can affect the real economy, with their belief that too much monetary accommodation causes bubbles. So everyone except one or two idiots accepts the principle that the Fed can cushion real shocks by monetary expansion. And as very visibly demonstrated, by increasing rates, everyone now accepts that if it chooses the Fed can slow growth or even push an economy into recession (for instance in the early 1980's when they hiked rates to kill inflation).

So the Fed can and should act in cases of real shocks and if they don't, then they are not doing their job.

ThaomasH writes:


I agree with ThaomasH. Forget about tight and loose. Just say it should have been tighter or looser than it was.

Thanks, but I think we can dispense with "tighter" and "looser." Just say what the CB should be doing in terms of whatever model you have. "In month X of year Y the CB should have moved instrument J from j0 to j1 in order to move target T from t0 to t1." I guess that in retrospect if a whole suite of instruments were used to increase the price level or the NGDP level, one might want to say that policy was "loose" as a kind of summary.

Don Geddis writes:

@Chris: "an active policy. ... a passive policy" You're trying to argue over definitions of words that don't serve a purpose. There is no significance to whether you label a central bank action as "active" or "passive". Perhaps your intended second (unstated) goal is to conclude, if the policy happened to be passive, that it "wasn't the central bank's fault". But that's not a valid conclusion; it merely means that the central bank should have been "active" instead (whatever that means). So there's really no point to try to nail down "active" vs. "passive" (even if the definitions weren't controversial -- but of course they are).

"But if that's true, then why would we be able to use NGDP as a measure of tightness when the Fed doesn't target NGDP?" Your use of the phrase "But if that's true" implies some sort of connection. But there's no connection at all between "active" vs. "passive", as compared to "tight" vs. "loose". The concepts are completely orthogonal.

The real answer, is that central banks only have a single lever. They can either make money tighter, or make it looser. If money is "tight", then we should expect inflation to fall and unemployment to rise. If money is "loose", then expect the reverse. If money is stable/neutral, then inflation & unemployment in the next period, should be about the same as they are in this period. (Market Monetarists suggest tracking the effect on "NGDP growth changes from trend", rather than "inflation", but that's a minor change.)

I think the best analogy is the utility analogy. Suppose you had a blackout because the power company hadn't drawn upon their huge hydroelectric dam on a hot day. You can surely blame the hot day (an exogenous shock) or the behaviour of thousands, turning on their air conditioning (the market), but the utility failed. If the utility has a legal monopoly, then it's a failure of regulation.

The same applies if the power grid goes down because the power company fails to turn off power on the weekend.

The public choice aspect is that the Fed does not want to be a utility. What's the fun in that?

Chris writes:


I agree, get rid of passive and active. That was my argument all along.

But I'm not trying to argue it wasn't the Fed's fault. I'm trying to argue that there is a difference between the Fed shocking the economy itself and the Fed failing to respond to a shock. If a police officer shoots somebody it's murder. If they simply fail to stop a murder that they could have stopped, they still failed to do their job, but they didn't cause the death.

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